How interest rates are set

The prime rate, as reported by the Wall Street Journal's bank survey, is among the most widely used benchmark in setting home equity lines of credit and credit card rates. It is in turn based on the fed funds rate, which is set by the Federal Reserve. The COFI (11th District cost of funds index) is a widely used benchmark for adjustable-rate mortgages.

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Prime rate, fed funds, COFI
By Bankrate.com

In the US, the Fed sets the fed funds rate (FFR) aka the target rate, and the overnight rate, or just the interest rate. This is the benchmark rate that banks use to figure their spread. The do this by adding their costs and profit based on risk to the base rate. The cost plus profit for the most creditworthy borrowers is the spread added to the FFR to arrive at the prime rate. This spread is ~3% for the prime rate. For example, the FFR is .25% and the prime rate is 3.25%. The rate charged less creditworthy borrowers is figured off the prime rate.

Therefore, although the Fed only controls the interest rate on reserves and not the amount banks charge for loans, it knows quite accurately how the prime rate will change with changes in the FFR. So it is by setting the FFR that the FED directly influences the rates that banks charge for credit. Owing to keen competition among banks, the prime rate is essentially the same for all banks and banks also are competitive in assessing risk to set rates for other borrowers.

The Fed has three options for setting the interest rate. It can:

• set the interest rate to zero;
• pay interest on reserves equal to the target rate;
• announce the target rate and adjust the supply of reserves available in the interbank market through open market operations (OMO), with the discount rate as ceiling, and with excess reserves have been drained through issuance of Treasury securities (bills, notes, bonds, and TIPS) through coordination with Treasury.

Ordinarily, the Fed uses OMO to hit the target rate. Presently, to the expansion of reserves because of quantitative easing (QE), the Fed is paying interest on reserves (IOR).

Some MMT economists, notably Warren Mosler, recommend that the Fed set the FFR to zero. See The Natural Rate of Interest Is Zero.

Update: Steve Randy Waldman sent a link to a post of his post via Twitter. It questions the prime rate as a benchmark rate. He offers a good rationale for thinking that the benchmark is LIBOR for the most creditworthy customers. The prime rate is only used as a benchmark rate for "the little people."

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